Keep Your Eye on the Credit Markets
A: Its what got us here in the first place! Credit is looking MUCH better - so keep your eyes on it and don't be fooled for a moment that the world is saved and nothing can bring us back to the hell we just came from! Credit has been leading the equity markets for the past 20 months or so; or I can say equities have been lagging the credit markets for the past 20 months or so, whichever you prefer. Looking at credit now, and where it has come from (always know where you came from!), its significantly improved! This is one reason why the stock market was ready for a sustainable fierce bear rally - as credit improves, investor confidence rises especially in financials that were severely beaten down. Ahh, but there is a danger with such renewed confidence! If you look today, credit is much tighter and many believe the fed/gov't has achieved their goals and fixed the financial problem for good! That is exactly when I want to get more worried - when hope creeps back in. All I am saying is, just keep your eye on credit, because if another wave is coming, it should show up in credit first just as it did in late 2007 and late 2008 before a sharp wave down came! Ignoring distress in credit markets at this stage of the game is highly dangerous - and I wonder now since credit has come in so much, are eyes starting to turn away?
Take a look at the significant improvement of some of the more widely used credit indicators to check in on the distress level in the financial markets:
TED Spread - measures the spread between 3-MTH Libor and 3-MTH Treasuries - normal being around 50bps. The wider the gap, the higher the level of distress because money flocks to safety in short term treasury market sending rates lower, at the same time lending between banks experiences a rise in credit risk, sending rates higher. The result is a widening gap. The TED spread is that gap and current is at 72.41:
3-MTH LIBOR - the rate at which banks lend to each other in London wholesale money markets; stands for London Interbank Offered Rate. Bringing LIBOR down was crucial in getting banks to lend to each other w/out fear and avoiding another wave of distress with adjustable rate mortgages due to reset higher - the last thing we needed for all those with ARMs. With LIBOR down so much many with adjustable mortgages actually reset to a lower rate! But before we start celebrating, know that its the recast that is more troubling. Here is 3-Mth LIBOR:
CORPORATE BOND SPREAD TO TREASURIES - spread between corporate bond yields and 10-YR treasury yields can tell us the level of distress in the corporate bond market. Like the TED Spread, a widening gap is a signal of distress in the corporate bond market as rising credit risk sends rates higher.
It's all in the natural order of markets. What amazes me the most is the dramatic shift in psychology from a 'financial Armageddon' scenario to a 'worst is over, V-shaped recovery' scenario over the course of the last 9 weeks! People really believe, and hope seems to be creeping in as the rally in equities, and specifically the financials, create the illusion that a new foundation for growth is set. Outside of fiscal stimulus and government jobs, what will drive growth for the years to come? And who says we won't get another wave of distress in the credit markets leading to higher interbank lending rates? Again, the natural order of markets at work.
This could last a bit longer as it seems blistering clear to me the stock market has been chosen to be the recaptilization vehicle for this latest round of money raising by the banks. Just look at bank stocks leading to the latest rounds of offerings (Goldman, Wells, BoA, Morgan Stanley, Northern Trust, Microsoft, Capital One, Ford, US Bancorp, KeyCorp, BB&T, Bank of NY Mellon, etc.) to raise capital via share dilution. Lets not kid ourselves here, the TARP kitty was running low and bank stocks were prime for a bear rally - the perfect setup for a short squeeze pumping the banks to levels that restore enough confidence as to allow for an offering. Some might say the game is rigged, but because it played out from the lows in the marketplace after a 60% drop in stocks, how can anybody argue that the banks were not ready for a rally?
While euphoria sets in now that the credit markets are on a path to more normal levels, focus starts to shift away from credit and onto growth expectations. I say, resist that urge because you might miss a reversal in the credit markets if one comes. It's an issue of belief here, and I am just not ready to believe that all is well. Its hard to declare us out of the woods with rising commercial delinquencies and the fact that defaults are spreading to higher quality debt classes.
Posted by lars
Tue May 12th, 2009 07:06 PM
Very good observation about credit being a leading indicator. I continue to use the rally to lighten my equity load to near zero. Only time will tell if that is the correct call.
Posted by Noah
Tue May 12th, 2009 07:46 PM
well its been that way for almost two years now, so until it changes, got to go with it. Although I sold my longs about 1-2 weeks ago, and built up some short positions, even without credit reversing course. Certainly tightening credit is helping the environment for the rally. I just think many dont believe credit will get as disrupted as it was, and that the real risk is over. Im not sure about that way of thinking
Posted by MeekSheep
Tue May 12th, 2009 08:42 PM
Good observations. I've pulled out of almost everything except short term corps., pipelines, and generic drugs. Waiting for the time when things go back to where they should be before I take that large cash cushion and put it to work.
Posted by Cons
Tue May 12th, 2009 09:26 PM
Great post - this is what I would add:
Definitively a C-Change in credit markets. New issuance of Corp (HY & IG) is up to $414B year to date which is already more than all of 2008 and possibly an all time record for year to date issuance. Even if you strip out FDIC guarantees, issuance is up big. Same story with HY and EM. Appetite is definitively back. And one last point in Jan and Fed when equities plunged HY held in and was pretty much flat - so not sure I would use that as a barometer for equity market direction. Spreads are still way wide. HY is at 11% versus long-term average of 5% and tight of 2.5% in '06, '07. Upside potential is still there.
Posted by mjiam
Tue May 12th, 2009 10:24 PM
Quietly and with little mention that I've seen, 5 year US CDS have hit a post Lehman low. 26 bps..Keep in mind that was in Mid-February, while the fed was still adding a few hundred billion a month to it's balance sheet and well before US budget deficit projections from the CBO were creeping up towards $1.8trn..All those continue and grow, so yes, we know perceptions ofsystemic risks have been reduced, the patient will live, and like Ben Button born in youth, it's expression will be a tad different than most expect. Frankly, the outlier across asset classes remains gold, which rolled in lockstep with US and other sovereign CDS spreads and has now disconnected...Technically, it looks ok, but I'm betting that by mid-summer, gold will see sub $700
Posted by William
Tue May 12th, 2009 11:44 PM
Just stumbled on this site - Good posts!...
TED SPread.. is right on.
Very impressive posts.
William.
Posted by mh23
Wed May 13th, 2009 08:08 AM
Noah:
Great post. I am very cautious with respect to stocks right now based upon he facts that they have had a huge move, coupled with the fact that, beginning in 2011, Obama's tax increases and regulatory reforms will be hitting the system and will most likely lead us into a new recession.
My sense is that, within the next 16 months the S and P will probably hit around 1k, at which point I will be selling all of my equity positions except:
GDX, DBA, OIH, EWZ, EWT, FXI and SLV.
As you know, I have been attracted to stock valuations over the past 9 months, however, I now am deeply concerned over the fact that the dollar is going to become very unattractive as fear abates and investors search for yield. Couple that with the fact that China and Russia seem to be more interested in buying Gold and Copper as opposed to US debt, and you have the makings of a real problem.
Right now, I am very bullish on GDX, because I believe that within the next 24-36 months Gold will hit ridiculous levels as the dollars takes a major hit. I am sure that you have noticed, as I have, that Gold has continued to perform well even in the midst of this equity rally, which is odd if you believe that an equity rally signifies the return of risk appetite. The dollar, although weaker, has still, up to this point held up, which leads me to think that the bull run for Gold is well under way.
Finally, were I to want to add some additional risk, yield to my portfolio, I would certainly be looking to bonds before stocks for the next several years for the reasons sighted by Pimco yesterday. I currently own a number of bond funds as well as some Met life Preferds, which have rallied from 8 in March, back up to 20 last week, which further bolsters your point about the credit markets.
Posted by Noah
Wed May 13th, 2009 08:45 AM
mjiam - ahhhh, its funny you say this. Did you see David Walkers call this morning that US may lose its AAA credit rating? Now, Im not sure that will happen, and as you say 5YR and 10YR US CDS have come in big time, but all you need is a perceived risk that US may lose its top rating and that would be enough to spark a crisis in our currency. Many believe that to be the main course of this crisis - we know the fed is holding tons of garbage and is highly leveraged on their balance sheet!
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=avc3Gx0gCLQ0
"The U.S.’s AAA debt rating may be cut because the government can’t control spending, David Walker, chief of the Peter G. Peterson Foundation and former U.S. comptroller general, wrote in the Financial Times newspaper."
Gold is hanging in there because of the QE policy, and there will be a HUGE rampup in treasury purchases, TRUST ME! I would take that bet on gold, and if gold falls to 700, Im loading up. I think there is a better chance gold rises to 1100 first, then fall to 700. But thats just me on the endgame here. Thats what makes a trade.
I got my gold from mid/high 600s, and longer dated calls. Im holding
Posted by Noah
Wed May 13th, 2009 09:03 AM
mh23 - always enjoy your comments. I am 60% in cash, money markets, CDs, 20% gold, and 20% in trading account that I am playing with. Its that 20% where I sold my longs about 1-2 weeks ago, and built up shorts - yes, took some pain but last few days has made up for it a bit (srs, fxp, eev, mzz, dxd).
FXI has been a great mover, but I must admit, Im long the ultrashort inverse of it now after hitting stop loss at 23 a while ago. Got a new position in high 15s - need to get to 17.50 or so to be flat on that trade from losses before stop loss hit. Anyway, I just think we have another wave down and I do think we will hit new lows and THEN we will have buying opp of a lifetime in equities. But, hope will be dashed for many if this fierce wave down does come. Who knows what may spark it, its just a gut feeling. And I could be very wrong - who knows in this market with what has been done by fed/treasury.
Posted by Fred
Wed May 13th, 2009 09:13 AM
TED spread is down again this AM, and narrowed even more after retail sales came out. All the analysis that made sense pre-October in large part no longer applies. The big unknown - a possible systemic default in banking - is now off the table, buried in the ground, awaiting reincarnation for a made for TV mini series in some distant galaxy far far away. My Roubini-meter is fast asleep and my counter intuition says this is just not a market to short any longer. Call it what you will but corporates are selling, even the frakkin REITs (which deserve more punishment) aren't budging. One could easily dismiss financials' common shares at this point because they've been effectively neutered. I like the preferreds still, especially trust preferreds b/c at least you are getting paid, but the real play at this point is raw materials, emerging markets (ex-Chindia) and energy. What DC will not come out and say, which I find very interesting, is anything about housing prices stabilizing - that's smart because they have downside, much more downside in NYC of course - but that sector is dead for the next five years. Finally, the main reason why DC will continue to prop up equities is because that is the only way out for the public pensions. It is not a story anyone in DC wants attention focused on because the size of the problem there is so huge, so mired in bad policy at the pension management level, that it makes Detroit/TARP/FNM look like an hors d'oeuvre. Imagine being the guy in charge who has to tell millions of pensioners that they have to take a 40%+ haircut in their benefits in effective perpetuity?
Posted by OT
Wed May 13th, 2009 09:38 AM
Noah - RE sales have shown a sizable uptick in the past week or two - care to comment?
Posted by Noah
Wed May 13th, 2009 09:41 AM
OT - yes I will write about that soon! This market is active, and units are going into contract, but it comes busy season. Ill make a discussion out of it
Posted by mh23
Wed May 13th, 2009 10:20 AM
Noah:
My allocation is not that much different than yours. I am 70% cash, 20% equities (of which a pick piece is GDX, OIH, DBA, and SLV) and 10% bonds. I had been 100% in cash until November 08, but I got lured into the market by panic selling. Right now, for the first time ever, I am actually concerned about a massive devaluation of the dollar. As you know, right now we are in, and have been in for a while, a deflationary environment, so the dollar has been working. However, with the Fed almost out of bullets, and fear abating, I can't imagine that yields will not be going up, which will set back any type of housing recovery as well as any real recovery from our recession. Couple that with higher taxes and a more invasive regulatory environment, and you have even more hurdles to growth.
You have been on top of this Gold trade for a while, and actually it was your arguments that led me to begin buying of GDX at around 31. The more I read about what is going on in China, Russia, and other central banks, the more I am starting to believe that the dollar is on the verge of major problems. In that type of scenario, Gold, Silver, Ag, Oil, and Copper, should outperform the market by an appreciable amount.
Posted by Thisson
Wed May 13th, 2009 12:25 PM
Hmm, I'm not sure I understand the rationale for a bullish position in gold: gold is supposed to go down when real interest rates rise, and there isn't much room for lower real rates, is there?
If you're purchasing gold as a hedge against inflation, isn't debt-financed real estate a better payoff on the same directional bet?
I'm seeing absolutely zero signs of inflation, anyway -- I think it's much more likely we have an extended deflationary period, despite all the printing the Fed is doing.
Posted by Noah
Wed May 13th, 2009 01:29 PM
anti-fiat currency trade when global CBs are printing their way out of a generational credit crisis. thats the gold trade, in my opinion and why many are confused as to golds move and/or lack of serious pullback even as other commodities rolled over. gold will be viewed as an alternate currency, in a very confusing and pressured time for fiat currencies.
this goes beyond the inflation, dollar plunges, metals and real estate surge. I doubt real estate will participate anywhere close to metals in response to a loss of confidence in paper money. This argument is an ongoing one
Posted by In Debt We Trust
Wed May 13th, 2009 02:58 PM
Food > gold. I've never heard of ppl eating gold before.
Posted by Noah
Wed May 13th, 2009 03:01 PM
and I think commodities and food prices will soar too. Nope, cant eat gold. I dont think it will get that bad. Hey, the markets need another bubble market, I think its highly likely its precious metals this time!
I dont see it getting to point where all you need is food, guns, and gold. Thats too much for me.
Posted by Thisson
Wed May 13th, 2009 04:10 PM
Noah, thanks for your explanation.
Bloomberg has an interesting article on gold and its comparison to other PMs:
http://www.bloomberg.com/apps/news?pid=20601109&sid=a2uWkHdbGk7U&refer=home
Posted by Noah
Wed May 13th, 2009 05:13 PM
Thisson - I dont think you have seen anything yet in regards to the precious metals. Just an opinion, and I could be wrong and will admit Im wrong if nothing happens by end of 2010. Just my gut feeling.